Volatility and liquidity; what is the relation between these 2 in stocks market ? How can you take advantage?
of it, Please analyze your theory and elaborate your answer
I know what they mean individually, the question is about their relation
Comments
volatility measures how likely it is to rise and fall.
liquidity measures how easy it is to sell it.
Generally I would say more liquidity would increase the volatility, since the more active a market is (or individual stock), the greater the "jumpiness" of the stock (technically volatility is the standard deviation of the % change (return) a stock undergoes, over a period of time). I actually wrote a paper for class on the effects of daytrading and higher trader volume on market volatility, but the evidence that more traders and higher trade volume (i.e. higher liquidity) causes more volatility was inconclusive. Needless to say, volatility offers traders and investors alike great opportunity for profit, if they can time trades right or find undervalued stocks during market downturns. I was actually doing the research to figure out whether or not there are more trading opportunities today than there was before electronic trading (and high trading volume) became possible. I found that volatility increased during the bull run of the mid to late 90′s, and stayed relatively constant until the end of the bear market in 2003. Volatility from 2003-2007 is actually low, compared to that previous period at least, and this is a sign of investor complacency. Generally speaking, I would say high trade volume predisposes a stock to high volatility (makes it more likely), but does not always actually lead to high volatility. Well, that’s the best I can do for you.
Volatility is related to several factors, and liquidity is only one of them.
Liquidity means different things in different contexts. In the context of volatility it means that there are always plenty of buyers and sellers whenever someone wants to buy or sell. Liquidity keeps the bid-ask spread small. Liquidity by itself may not reduce the volatility of a stock, but a lack of liquidity can definitely cause wild volatility. Think about it. You want to sell your shares of XYZ, but there are no immediate buyers. You have to lower your price drastically if you want to sell soon. Meanwhile, the fundamental situation, which is why you’re selling in the first place, is rapidly deteriorating. You can’t sell fast enough, and the price keeps dropping. Of course, it might go in the opposite direction also, when prices are rising.
This is, in part, why stocks that are thinly traded tend to be much more volatile than more "liquid" stocks. I own some shares of a penny stock that has a small float, and daily price fluctations of 10-20% are not at all unusual.
June 23rd, 2010 at 3:09 pm
Volatility of a stock is measured by its Beta. If its Beta is 1.25, the price of that stock will go up or down 25% more than the market in general, compared to the Dow Jones industrial average or the S&P 500. If its Beta is 0. 75, the price of that stock will go up or down only 75% as much as the market.
Liquidity is often measured by the daily volume (Number of shares sold) of the stock. If the volume is real low, you might not be able to sell your shares very quickly. That means the stock has low liquidity.
There is not always a direct relationship between volatility and liquidity.